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Popular discussions about the advisability of
recent tax cuts have frequently ignored a simple truism: someone,
somewhere, at some time will have to pay for them. The payment may be in
the form of increases in other taxes, reductions in government programs, or
some combination of the two; the payment may occur now or later; it may be
transparent or hidden. But iron laws of arithmetic and fiscal solvency
tell us that the payment has to occur.

Some tax-cut advocates try to deny
the fundamental fact that the tax cuts will need to be paid for. For example,
some claim the cuts will generate enough economic growth to “pay for
themselves.” As discussed below, the evidence not only does not support such
claims, it implies precisely the opposite result — that sustained deficit
financing of tax cuts will end up reducing long-term economic growth, thereby
raising the cost of the tax cuts. Others claim the repayment can be postponed
indefinitely. But given the nation’s large underlying long-term fiscal
imbalance even without the tax cuts, such indefinite postponement of paying
for the tax cuts is simply not possible — it eventually would spark a serious
fiscal crisis. (Similarly, large increases in spending, such as occurred with
the enactment of the Medicare drug benefit, will also need to be paid for.)

To date, the tax cuts have been
funded with increased borrowing. This postpones but does not eliminate the
required payments.[2]
It can also create the misleading impression that tax cuts make almost
everyone better off because the direct tax-cut benefits are immediate and
quantifiable but the ultimate costs are delayed and disguised and thus often
ignored.

The central goal of
this analysis is to correct this misleading impression by showing not only who
benefits directly from the recent tax cuts but also who benefits and who loses
once the financing of the tax cuts is considered. Specifically, we examine
the distribution of the 2001 and 2003 tax cuts (once they are fully in effect
and reflecting the President’s proposal to make most of these tax cuts
permanent) combined with the costs of paying for those tax cuts. We
therefore examine the “net effects” of the tax cuts, accounting for both the
direct benefits and the costs associated with financing those benefits.

Because there is uncertainty about
how the tax cuts will ultimately be financed, we examine two hypothetical
scenarios. In both scenarios, the burdens are set so that the annual cost of
the tax cuts (when fully phased in) would be paid for fully — so that the net
effect of the tax cuts that year on the budget thus would be zero.

The first scenario assumes that
each household pays an equal dollar amount each year to finance the tax
cuts. Under this scenario, each household receives a direct tax cut based on
the 2001 and 2003 legislation, but it also “pays” $1,520 per year in some
combination of reductions in benefits from government spending or increases in
other taxes to finance the 2001 and 2003 tax cuts. Something close to this
scenario could occur if the tax cuts were financed largely or entirely through
spending cuts. We refer to this as the “equal dollar burden” scenario.

The second scenario assumes that each household pays the same percentage of
income to finance the tax cuts. Under this scenario, each household
receives a direct tax cut based on the 2001 and 2003 legislation, but it also
pays 2.6 percent of its income each year. Something close to this scenario
could occur if the tax cuts were financed through a combination of spending
cuts and progressive tax increases. We refer to this as the “proportional
burden” scenario.

We estimate the effects of these
two scenarios on households at different income levels, using the Tax Policy
Center microsimulation model.[3]

Table 1Average Change in
Incomes Under the Tax Cuts with Cost of
Financing Included, Two Hypothetical Scenarios(annual effects, in 2004 dollars)

Income Class

Average tax cut

Average net effect, financing with equal
dollar burden per household

Average net effect, financing with payments proportional to income

Bottom 20 percent

$19

-$1,502

-$177

Middle 20 percent

652

-869

-$228

Over $1 million

136,398

134,877

$59,637

Source: Urban-Brookings Tax Policy
Center microsimulation model

Our principal findings include the
following:

Winners and Losers by Group

On average, the bottom
four-fifths of households — households with income below about $76,400 — would
lose more than they gain from the tax cuts once the necessary financing is
taken into account. That is, once the need for financing is included, the
2001 and 2003 “tax cuts” are best seen as net tax cuts for the top 20
percent of households as a group, financed by net tax increases or benefit
reductions for the remaining 80 percent of the population as a group.

Middle-income households would be worse off under both scenarios for
financing the tax cuts, but would fare much worse if tax cuts are financed
entirely on an equal dollar burden basis (such as could occur if the
adjustment were largely or entirely undertaken through spending cuts).
Under the equal dollar burden scenario, the middle fifth of households would
lose an average of $869 per year (Table 1) or 3.1 percent of their after-tax
incomes (Table 2). (The average direct tax cut for these households is
$652. Coupled with a financing burden of $1,520, the net effect is an
average loss of $869, or 3.1 percent of their after-tax incomes.)
Under the proportional burden scenario (which could occur through a mixture
of spending cuts and progressive tax increases), the middle fifth of
households would lose an average of $228 a year. This is substantially
smaller than the losses under an equal dollar burden scenario, but it still
amounts to 0.8 percent of their after-tax income.

Table 2Percentage Change
in After-tax Incomes Under the Tax Cuts with the
Cost of Financing Included, Two Hypothetical Scenarios(annual effects, in 2004 dollars)

Income Class

Average tax cut (as a percentage of after-tax income)

Average net effect, financing with equal
dollar burden per household

Average net effect, financing with payments proportional to income

Bottom 20 percent

0.3%

-21.1%

-2.5%

Middle 20 percent

2.3%

-3.1%

-0.8%

Over $1 million

7.1%

7.0%

3.1%

Source: Urban-Brookings Tax Policy
Center microsimulation model

Low-income households would be
worse off under either scenario, but face potentially enormous costs if the
tax cuts are financed entirely on an equal dollar burden basis.
Low-income households would be hit extremely hard under the equal dollar
burden approach to financing the tax cuts. They gain little from the tax cuts
and would lose much from reductions in spending programs, which often target
them, that would result in an equal dollar burden per household. On average,
they would lose an average of just over $1,500 a year, or 21 percent of their
income. Under proportional financing (which would very likely reflect less of
a reliance on spending cuts), they lose about 2.5 percent of their after-tax
income on average.

Conversely, high-income
households would be net winners, and the gains among the highest-income
households would be large. People with annual incomes of more than $1
million would gain an average of $59,600 a year — a 3.1 percent gain in
after-tax income — under the proportional burden scenario and $135,000 a year
— or 7 percent of income — under the equal dollar scenario. High-income
households are hit less than other households by spending cuts, which are
likely to play a more dominant role in the equal dollar burden scenario.

The net transfer in resources
from low- and middle-income households to high-income households would be
sizable. The overall transfer of income from the lower four-fifths of
households with incomes of less than $76,400 to households with higher incomes
would amount to $113 billion per year under the equal dollar scenario and $27
billion per year under the proportional financing scenario. The overall
increase in the incomes of households whose incomes exceed $1 million a year
would be $35 billion a year under the equal burden scenario and $15 billion a
year under the proportional scenario. (See Table 3.)

Table 3
Total Dollar Effect of the Tax Cuts with Cost of Financing Included,
Two Hypothetical Scenarios
(annual effects, in 2004 dollars)

Income Class

Average net effect, financing with equal
dollar burden per household

Average net effect, financing with payments proportional to income

Bottom 80 percent

-$113 billion

-$27 billion

Top 20 percent

+$113 billion

+$27 billion

Over $1 million

+$35 billion

+$15 billion

Source: Urban-Brookings Tax Policy
Center microsimulation model

Individual Winners and Losers

The above data focus on how groups would fare
on average. The Tax Policy Center model also allows determination of how
many individual households would wind up better off and how many worse off.

Under both of the financing
scenarios, more than three out of every four households would ultimately lose
more than they gain from the tax cuts. The net “losers” would be
concentrated among low- and middle-income households. For instance, under the
equal dollar burden scenario, nine of every 10 households in the middle fifth
of the income distribution would lose more from the tax cuts than they would
gain, and nearly all of the households in the bottom two-fifths of the income
distribution would come out as net losers.

Conclusion

The tax cuts are often
portrayed by their supporters as painless and simply “giving people their
money back.” But the numbers presented above indicate that the substantial
majority of American households ultimately will be made worse off by the tax
cuts, because the tax cuts ultimately will have to be financed. Different
methods of financing would generate variation in the particular results, but
this basic finding that most households end up being worse off is likely to
continue to hold unless a significant portion of the tax cuts themselves are
repealed. The reason is that the tax cuts scale back (or even eliminate) many
of the most progressive elements of the federal tax system, including the
estate tax, the taxation of capital gains and dividends, the top income tax
rates, and the phase-outs of certain exemptions and deductions for households
with high incomes. It is unlikely that any method of financing those changes,
other than repeal, will be as progressive as the tax provisions that have been
scaled back.